Monday, March 23, 2015

Strategies to minimize US taxes when there is no tax treaty

If you do business in the US but there is no tax treaty between the US and the country where your foreign business is registered (e.g. Singapore, Malaysia, UAE, Brazil, Colombia and others), you may be subject to some of the highest taxes in the world for the profits from your US operations. Here are certain strategies to circumvent this.

Tax-free repatriation of profits

Your US investors, accountants or business associates may insist you form a corporation and not a partnership, LLC or a “branch” of your foreign business. US corporations have many advantages over the other aforementioned business forms but the major drawback of corporations is that they are normally subject to double taxation. The profits earned by a C-corp subsidiary of your foreign company will be subject to 15-35% tax in the US. Further, dividend distribution by the US subsidiary to the parent is subject to a withholding tax of 30%. What to do? Instead of distributing dividends, you can sell the US subsidiary’s stock or liquidate the company. When a foreign (non-US) corporation sells the stock of a domestic US corporation, no tax is generally imposed. The United States does not impose an income tax on non-resident individuals or corporations when they dispose of stock of a domestic US corporation. Foreign shareholders receiving distributions in liquidation of the U.S. corporation are generally not subject to the gross basis tax applicable to dividend distributions.

Offset losses against gains

A good thing about corporations is that it’s possible to offset years of losses against years of gains to further lower your tax liability. If allowable deductions exceed a corporation’s gross income, the excess is called a net operating loss (NOL). In general, NOLs may be carried back 2 years and forward 20 years to offset taxable income for those years. Capital losses can be carried forward five years and carried back three years solely to offset capital gains. However, the carryback is only available if the capital loss does not create or increase an NOL. Domestic (US) corporations (and not their foreign parents) are required to report their taxable income on a Form 1120 every year and pay tax due thereon. Domestic corporations are subject to corporate income tax at rates ranging from approximately 15% to 35%.

Interest on loans

An alternative to earnings repatriation can be the receipt of interest on loans made to the corporation by its shareholder. This method has an advantage over repatriation by dividend distributions. The corporation may realize an interest deduction for the amount paid to its shareholder as opposed to the lack of deduction for amounts paid as a dividend. This deduction lowers the corporation’s U.S. taxable income and its U.S. corporate tax liability. Interest may also be exempt under internal U.S. law, e.g. the portfolio interest exemption.

LLC

Forming an LLC instead of a corporation can help minimize taxes. LLC’s are not double taxed because LLC is a “disregarded entity” for tax purposes. So, the LLC’s members’ income via the LLC will be taxed only once on the members’ personal tax returns. LLC’s are easy to set up and maintain, as there are less formalities involved in operating an LLC. So, why would anyone ever bother forming a corporation instead of LLC? Investors prefer to invest in corporations for reasons I shall cover in other posts. When you are ready to negotiate with potential investors you can convert your LLC to a corp if that’s what they prefer and then see if you can utilize the aforementioned strategies for profit repatriation.

Other business structures (e.g. partnership, US “branch” of a foreign parent, etc.) can also circumvent double taxation but those types of structures offer less liability protections, so I will not discuss them here.

Which state?

In what US state should you set up your US based entity to help minimize tax burden? Most likely, in Delaware. The answer to the question in what state to form a company usually comes down to two options: 1) Delaware and 2) in whichever state you have physical business presence (offices, stores, etc.). If you business is software, you will probably not have a major presence in any particular state. If that’s the case, DE is the safest, most established choice. DE will not tax you at the state level as long as you don’t have any servers, offices or major business transactions in that state.